Five winning traits investors should look for while navigating the small and mid-cap minefield
Peter Hodson: Sure smaller companies are riskier, but they also tend to grow faster and can provide bigger returns
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On a professional basis, I have now been analyzing small and mid-capitalization companies for more than 30 years. Smaller companies, in my view, are just more fun. Sure, they are riskier than larger, more-established companies. But they are also typically growing faster, and can provide greater investment returns. You just have to be careful, and know what to watch out for. There are dozens of warning signs one can pick up on for small companies, and we will cover these in a later column. But for now, let’s focus on some things to look for, when trying to find a good small or mid-cap investment idea. We will try to list some company examples, as well.
Management
There is a reason why analysts and portfolio managers always say that management of a company is the most important factor to look at — because it is. This is even more true with a smaller company, because senior management has the vision, the expertise and the motivation (through stock ownership) to drive the company forward. Sure, large companies have lots of experienced managers as well. But smaller companies tend to have managers that live, breathe and sleep their company 24 hours a day. Many managers have their entire net worth at risk in their own company. We like this. Frankly, we want the managers of the companies we buy to be lying awake at night worrying about their business. If they are lying awake, we can sleep better. One example is Well Health Technologies (WELL on TSX). The executive team, led by Hamed Shahbazi, has grown (and sold) companies before. Our clients did well on TIO Networks, Shahbazi’s prior company, which was sold to Paypal in 2017 for $300 million. The team knows how to grow a company. Well’s shares are up 363 per cent in the past year, so are certainly off to a good start. Insiders own about 16 per cent.
Sponsorship
We like it when a smaller company has a “big brother” — that is, a larger company with a vested interest in it. In the large cap universe, this is exemplified by the Brookfield Group of companies, where Brookfield Asset Management (BAM.A on TSX) owns between 10 per cent and 50 per cent of many other companies, providing guidance, support, financing and, occasionally, a buy-out. In the mid-cap arena, we have really warmed up to Topicus Inc. (TOI on Venture), a new listing this year, spun out of Constellation Software (CSU on TSX). Constellation owns 30 per cent of Topicus, and fully controls the votes. We can’t see how it is a bad thing for Topicus to be controlled by the company that has had one of the best stock performances in Canada over the past decade. Many see Topicus as a ‘mini’ Constellation, and we would agree with this assessment. How is this relationship going so far? Well, Topicus shares are up 40 per cent since their listing less than three months ago.
New and big market opportunity
We like it when small companies go after new markets. Most investors know that gaming, e-sports and gambling are rapidly-emerging markets. Small companies moving fast in such markets are often at an advantage over larger, slower-moving large-cap companies. Case in point: Enthusiast Gaming Holdings (EGLX on TSX). Enthusiast has a dedicated network of more than 300 million gamers, and has started to monetize its customers. It has raised money and had more than $127 million in revenue last year. The gaming market has many years of assured growth ahead of it, and, while nothing is guaranteed, Enthusiast is off to a good start. If it can maintain its growth it should be able to capture a growing share of a large market. The stock is up more than 100 per cent already this year. Growth has been likely “pulled forward” by the pandemic, but that’s not necessarily a bad thing. Insiders still own 20 per cent of the company.
Balance sheet and sector
If you have been reading anything recently, you should know that there is a global shortage of semi-conductors. Car factories have stopped production, and other industries are feeling the pinch. Semi-conductor companies thusly are practically guaranteed to start looking to add more production capacity. Intel (INTC on Nasdaq) has already announced US$20 billion in new facilities. Its stock is up 30 per cent this year. But there is far more torque in smaller companies that provide capital equipment to the larger companies. Ichor Holdings (ICHR on Nasdaq), for example, makes critical fluid handling equipment for the sector. Shares are up 95 per cent this year and likely have room to grow. In Canada, we like Photon Control (PHO on TSX), up 36 per cent this year. It also provides semi-conductor manufacturing equipment. Both companies are also right now net debt-free, which reduces some risk in a typically-volatile sector.
Limited promotion plus dividends
When we pen our column on what to watch out for with small caps, we will have plenty to discuss on how stock promotion can be a negative sign. Promotion sets up high expectations. And, as any investor knows, high expectations are often met with disappointment in reality. So, ironically, we prefer little promotion. This way, companies can attract attention with fundamental performance, and not press releases. Put another way, if we are hearing about a stock, then no doubt thousands of others are as well. One small company that does not do much promotion is Sylogist Ltd. (SYZ on TSX). A small software provider, its shares are up 92 per cent in the past year, despite not many press releases. What’s more, and another thing we like with small companies, is its dividend. Current yield is 3.2 per cent, and it has raised its dividend four times in the past three years. For those paying attention to the prior point above, it also had $40 million net cash at the end of 2020.
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Peter Hodson, April 15, 2021
Peter Hodson, CFA, is Founder and Head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. Peter is also Associate Portfolio Manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned).
Source
https://financialpost.com/investing/five-winning-traits-investors-should-look-for-while-navigating-the-small-and-mid-cap-minefield
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